FINA 6273 (Part 2)
CASES IN FINA. MGMT & INVT BANKING
WINFIIELD REFUSE MANAGEMENT, INC.
Prof. Neil G. Cohen
Prepared by: Jin Yikai
Oct 27 2014
1. What are the annual cash outlays associated with the bond issue and the stock issue? Sheen’s idea (finance with bond) is to issue $125M bond with an annual interest rate of 6.5% and mature in 15 years. Annual principal repayment is $6.25M and leave $37.5M outstanding at maturity. The cash outlay is $6.25M every year besides the interest. See graph below.
If finance by equity, Winfield would issue 7.5M new shares @ $17.75 and keep a constant dividend policy of $1.00/Share. The actual cash outlay is $7.5M every year.
2. Respond to each director's assessment of the financing decision with a short paragraph - as if you are talking to each none in person during a meeting. 2.1 Andrea Winfield: Financing by stock has lower cost while issuing new debt would increase risk of swings in stock price Yikai Jin: Actually, financing by stock is more expensive (7.5M vs 6.25M). Winfield can meet debt obligations under varying EBIT scenarios. Besides, debt will increase EPS and ROE, increasing stock price. 2.2 Joseph Winfield: By issuing 7.5M shares, Winfield will only have to pay $7.5M in dividends. Yikai Jin: Debt cash outflows with debt is for a finite period while stock dividend outflows are perpetual 2.3 Ted Kale: Market price is too low (compared to peers with P/B). Issuing shares at low price and loss of management control is a disservice to current stockholders. Yikai Jin: We can’t decide financing method only by P/B. Price may be low due to a liquidity discount to trade OTC. In fact, P/B is not comparable when capital structure varies. 2.4 Joseph Tendi: Principal repayment obligation is irrelevant to the financing decision. Yikai Jin: Principal repayment is relevant because it is a real cash outflow 2.5 James Gitanga: Other major companies have long-term debt in capital structure while Winfield is unusual. Yikai Jin: Analysis shows Winfield has the capacity to take-on more debt in its capital structure. 3. Interpret the EBIT Chart shown in the case - explain what it means. See Chapter 7 where it is explained. The debt line is steeper than the equity line because use of debt financing causes EPS to change at a greater rate as EBIT changes – the essence of financial leverage. The double-edged sword aspect of financial leverage – as the lines diverge from the indifference level the gap between EPS with debt and EPS with equity widens. The right-hand divergence is good - financial leverage helps. The left-hand divergence is bad – financial leverage hurts. The EBIT Chart helps display the EBIT-EPS relationship for any level of EBIT in any year.
4. Recommend the financing choice, using the Income, Risk, Control, Marketability, Flexibility, Timing grid as explained in Chapter 7 of the Cohen Finance Book. Suppose I have four alternatives totally:
a) Debt with Fixed Principal Repayments
b) Debt without Fixed Principal Repayments
d) Debt & Equity (75% debt & 25% equity)
Firstly I calculate the cost of financing, the assumptions are as following: Assumptions
Marginal Tax Rate
Market Risk Premium
Risk-free Rate (Rf)
Cost of Equity (Ke)
Cost of Debt (Kd)
Time horizon (Years)
Dividend per share
I get the NPV of the cost of financing, from which I can see that among all the financing options considered, Debt (with no principal repayments) has the lowest NPV cost whereas Equity has the highest NPV cost.
Secondly, from the answer of question 3 we can see that as long as the EBIT is higher than $24.35M, the EPS of debt financing is higher than the EPS of equity financing, the higher the EBIT would be, the more different it would be. At last I check the ROE of the alternatives.
Pre-acquisition ROE: 4.01%
In conclusion, among the three criteria I use in comprising (Cost of...
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